Newcastle Investment Corp. (NCT) Q3 2011 Earnings Call November 9, 2011 9:00 AM ET
Ivy Hernandez – IR
Ken Riis – President and CEO
Wes Edens – Chairman
Brian Sigman – CFO
Matthew Howlett – Macquarie
Joshua Barber – Stifel Nicolaus
Good morning. My name is Stephanie, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Newcastle Third Quarter Earnings Conference Call. (Operator Instructions) After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.
I’d now like to turn the conference over to Ivy Hernandez. Please go ahead.
Thanks and good morning, everyone. I’d like to welcome you today, November 9th, 2011, to Newcastle’s Third Quarter 2011 Earnings Conference Call. Joining us today are Ken Riis, our CEO and President; Wes Edens, the Chairman of our Board of Directors; and Brian Sigman, our CFO.
Before I turn the call over to Ken, I would like to point out that certain statements made today maybe forward looking statements. Forward looking statements are not statements of fact instead these statements describe the company’s current beliefs regarding events that by their nature are uncertain and outside of the company’s control.
The company’s actual results may differ materially from the estimates or expectations expressed in any forward looking statements. So you should not place undue reliance on any forward looking statements. I encourage you to review the disclaimers in our earnings release regarding forward-looking statements and expected returns and to review the risk factors contained in our Annual and Quarterly Reports filed with the SEC.
Now, I’d like to turn the call over to Ken.
Thanks Ivy. Good morning and thank you for joining our third quarter 2011 conference call. In a third quarter where markets were turbulent, we had a very good quarter at Newcastle. Today there are three things I want to highlight on this call. First, our operating results. Second, our investment activity and third the increased over-collateralization in one of our CDOs that’s material to us.
Our operating results continue to improve. We generated $31 million or $0.39 per share of core operating earnings $0.02 higher than last quarter. Cash flow from operations was stable quarter-over-quarter at $15 million. In addition, we received $9 million of unrestricted cash from principal repayments at par on CDOs that were purchased at an average price of 57% of par. This 43 points or $4 million of discount earned along with the $15 million of operating cash flow is the cash that we used to set and pay our dividends. In the third quarter, we increased our common dividends to $0.15 per share and paid total common dividends of $16 million.
Now moving on to our third quarter investment activity. We didn’t invest a lot of unrestricted cash on our balance sheet. But our investment activity in our CDOs was robust. We took advantage of the declining security prices and put a lot of CDO cash to work at the end of the quarter.
In total, we invested $185 million of restricted cash at an expected unleveraged yield of 10%. Due to the low funding cost of 3% and inherent leverage provided by our CDOs, investing at an unleveraged return of 10% result in leverage returns of 30% or more. The bulk of our CDO cash was invested in real estate securities and a commercial real estate mezzanine loan. We invested in $115 million of cash in CMBS, ABS and CDO securities, 98 of the $115 million was invested in CMBS bonds. The risk return profile of these CMBS investments is compelling.
The average purchase price was 77 and our expected unleveraged yield is 11%. The investments had an average credit rating of BBB, average credit enhancement of 9% and an average loan to value of 65%. We also invested $70 million of CDO cash in one mezzanine loan secured by 13 hotel properties. Our mezzanine loan represents a 53% loan-to-value. We paid par for the loan, and will earn a spread of 7% over one month LIBOR with a minimum coupon of 8%.
I also want to highlight our activity at one of our CDOs that generates material cash flow to us. In the quarter, we increased the over collateralization in CDO 10 from $25 million to $106 million through a combination of CDO debt cancellation and discount asset purchases. We canceled $42 million of debt and purchased $145 million face amount of assets at an average dollar price of $75. This increase in OC dramatically derisked the deal and the $6 million of quarterly cash flows earned by us in CDO 10 is now more reliable.
Finally, I want to discuss our near term investment focus. Today, having cash to invest is a big advantage. At the end of the third quarter, we raised new equity capital and we now have $190 million of unrestricted cash to invest.
We have been patient putting this capital to work and that patience has paid off. Today, asset prices are lower and yields are higher than they were when we raised the capital. We are seeing a very large pipeline of new investments. And as we talked about our most recent capital raise, our immediate focus is to invest in the excess interest of mortgage servicing rights.
Now to discuss that strategy further, I’ll now hand it over to Wes Edens, our Chairman, Wes?
Thanks, Ken. Hello everyone, just a couple of minutes on as an update as to what we are currently doing on the area of the mortgage servicing rights. As many of you know when we raised capital at the end of September, we talked a lot about what we pursue to be a tremendous opportunity in the marketplace.
Little bit of context, the mortgage servicing are the rights to receive payments for servicing residential mortgage loans it’s a very large market. Market in nominal terms is about $10.4 trillion, so a market value of well over $100 billion of value of the asset class. It is a market that historically has been dominated by the banks. The top four banks represent more than half of the current market share, non-banks service less than 5% but we think for a whole variety of reasons this is something that is in the process of changing dramatically.
The combination of regulatory accounting legal issues as well as just the headline exposure of the banks has created substantial amount of selling by them. The pipeline of actionable investments that we’re looking at right now is in excess of $400 billion. So in round terms if the value of the service is worth about a point and that’s a broad generalization, but it’s a good (inaudible).
We got $3.5 billion to $4.5 billion of assets that we think are likely to be sold in the near-term. And the economics of them are extremely attractive. I mean, basically the core determinant value of the mortgage servicing right is something how long do the loan stay on your books, either directly or in the form that you buy directly or indirectly, if you refinanced that loan and you continue to own that mortgage servicing rate.
So obviously with interest rate being at the lowest point they’ve been since anyone on this phone has been alive, it’s an extremely compelling time to be looking at these investments. That plus just the technical pressures in the parts of the banks, we think leads to a great opportunity.
We have one material piece of news, something that we were hopeful a lot of the time we were raising the capital, but it’s turned into something that in fact has come to pass. We received a private letter ruling from the IRS that allows us to qualify the excess interest in mortgage servicing as a qualified read asset.
Obviously when we went to the IRS and asked them for ruling on this, we thought it was sensible that they would rule in this manner because these are in fact just payments, the portion of the payments from the mortgage loan and that would seem to be logical, they would do that but of course we want to get the clarity from the IRS, we did so. We now have that ruling in hand, therefore the excess servicing is to qualified re-asset and the income generated from it be treated as good read income and therefore an investment vehicle like Newcastle is really the ideal vehicle to hold that.
So we’re excited about it, as Kenny said our timing couldn’t be better, servicing prices declined in the third quarter as we got this latest uptick in prepayments fees some of concerns about (inaudible).
We’re working very hard on two separate transactions both of which I am optimistic are going to come to pass, I mean basically the structure that we’re pursuing is exactly what we told you we are doing, which is based to partner up with a high quality servicer that has sufficient capital. It also has a lot of origination capabilities. So we can share in the re-origination of loans, and thus extend the life time of these investments investor return profile for them.
We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.
Our goal is to invest or commit on a substantial amount of our liquidity, so if you can find good investments here. And as we do so, we intend to give you kind of a public notice, so that you will be able to keep track what we are doing, but this is an exciting moment, things are seem to be coming together as well, and hopefully we will ask some good news probably on the shortly.
With that, I will turn over the Brain just to wrap things up. Brian?
Thanks, Wes. Good morning, everyone. Today, Ken will review the Newcastle and the market. I’ll drill down on our liquidity and financial results for the quarter. With respect to our liquidity, we currently have a $190 million of unrestricted cash and $84 million of restricted cash for the investment, primarily all of which is in CDOs IX and X. We have$12 million repurchase agreements that it’s financing $33 million of our CDOs VI senior bonds that we purchased last December.
The recourse of the company is limited to 25% of the outstanding balance of the repurchase facility, which was only $3 million at quarter end. We also have $207 million of repurchase agreements that are financing $208 million phase of Fannie Mae and Freddie Mac one year ARM securities. We use this type of investment and related financing for compliance purposes for the investment company after 1940.
Now on to our financial results for the quarter. We had GAAP income of $0.35 per share representing three main components. First, core earnings of $0.39 per share, second, we had other income of $0.23 per share primarily due to a gain of $0.20 per share on the repurchase of our own CDO debt and a net gain of $0.07 per share on the sale of real estate securities. These gains were offset by a loss of $0.03 per share primarily resulted from mark-to-market loss and our interest rate derivatives in our CDOs.
Third a $0.27 per share in net mark-to-market loss on our loans held for sale and impairment recorded on 10 real estate securities. Adding these components of $0.39, $0.23 and subtracting the $0.27 gets us to our GAAP income for the quarter of $0.35 per share.
Lastly, I’d like to touch on some key points. As Ken mentioned, during the quarter we are very active investing the cash within our CDOs. Since quarter end we’ve invested most of the cash in CDO VIII and currently have $2 million remaining that we’ll be investing in the next week prior to the final reinvestment date.
During the quarter, we finalized our 2010 taxable income and have disclosed as of December 31, 2010 we had a net operating loss carried forward of $675 million and a net capital loss carried forward to $375 million.
Finally, I’d like to point out that as of September 30; we reclassified our residential mortgage loan portfolio to finance the long-term non-recourse debt to help for investments. This reclassification is consistent with our intent and ability and it’s shown on the balance sheet accordingly.
That ends our prepared remarks. We’ll now take your questions. Operator?
(Operator Instructions). Your first question comes from the line of Matthew Howlett with Macquarie.
Matthew Howlett – Macquarie
Hey guys, thanks for taking my question. Just on the MSR, congrats on the ruling for qualified asset. Going forward, what’s the strategy with regard to that asset? I mean, how big the portfolio could that be? I mean, what’s your thinking around that?
Well, is it so less? We don’t know how prolific the investment environment. And I’d say based on this year’s size and volumes that we see in the marketplace right now and what seems to be real buyer's opportunity, it could be substantial portion of our investment activity going forward. We’ve got the core activities that Ken and Brian were talking about. Here we think are going to continue to produce lots of opportunities for us on our existing CDOs but there is not really a good new CDO market that exist today like the spreads and liabilities versus the assets are not really compelling in terms of new stuff.
There may be lots of opportunities to bind older bust of things where there is a whole variety of things that we are looking at right now. But the MSR opportunity on standalone basis is something that we think there is really compelling. It could be significant. And as we start to make these investments, we’ll tell everyone what’s going on and I think that what we wait and see how it all turns up.
Matthew Howlett – Macquarie
And then, Wes reminds us again, with the MSRs you access interest, I mean, the concern with buying those assets would be modification HARP 2.0 and so forth. With the origination capabilities of Nationstar, does that risk contained given most modifications would happen with inside the same servicing and Nationstar originate and refinance.
Yeah. In the way I think of that in the kind of simple terms is that what you want as an investors, you want that loan in whatever form to stick around as long as possible, right because you’re going to receive interest half of its mortgage payments for an indefinite period of time. Modifications actually could be very constructive because you continue to earn, you can modify the terms of loans but the servicing right typically would stay as is. So if that extended life of loan is the right thing for the borrower. That’s a good thing. The only thing you’re really concerned about our loans that are no longer been serviced in the pool. And there’s only two ways for that to happen one is, they can prepay; or the two is, they can default and go and away.
On the prepayment side, to the extent that your partner is an originator of loans, and you can recapture in a fact those loans that prepay and keep them in the pool that actually is a substantial dampen or in terms of the prepayment characteristics of loan pool in the value rather.
So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it would be prudent, but the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.
Matthew Howlett – Macquarie
All right, thanks. That’s going to be an interesting asset class going forward. And sort of my commend you guys on leading the way in terms of REITs and getting that asset. Just switching to the cash flows from operations were strong and stable like you said. But the principal repayments from repurchased CDOs, that went down. I know that’s volatile. Is that just a function of how you manage the CDOs that are you’re your reinvestment period? In other words, did you not sell as many securities that would have allowed you to gain more cash flow on those senior tranches?
Yeah. Yeah Matt, this is Ken. It really is a function of either maturing debt that pays off or asset sales that we engage in the quarter on deals that are past our reinvestment period. So you’re right, the cash flows and the principle of return will be lumpy. In the second quarter, it was higher this quarter it was $9 million. I don’t think it would be much lower than $9 million on a quarterly basis. But, it really is subject to the underlying loan prepayments and particular assets sales that we engage in each CDO.
Your next question comes from the line of Joshua Barber with Stifel Nicolaus.
Joshua Barber – Stifel Nicolaus
Hi, good morning. I was wondering, that you can make some more comment on the MSR’s, and Ken if you had made some comments earlier about assets spreads having come out, since you guys have raised equity. And given that MSR’s are effectively IO-strips or the things that you could invest incomparable or even slightly lower IRRs. But that would actually have probably better or similar return characteristics today that would probably make you rethink the whole MSR strategy?
Well, not at all (inaudible). There is not really an MSR strategy on the one hand and an investment security strategy on the other. We really look at trying to make the best risk adjusted returns that we can. The company has done a terrific job in the last couple of years in harvesting the opportunities that have come out of the existing bond portfolios and we think that those are going to continue and chances to deploy capital, not only inside the debt structures but also incremental capital on balance sheet.
So, those are things we’re looking at all the time. We think that’s a big part of it. The mortgage servicing rights as an asset class is a very interesting asset class from an investment characteristic and particularly given the interest rate environment that we are in right now. On top of that, you have really for the first time ever, since I’ve been around it, you have a substantial amount of selling buybacks in the past, the investment opportunity but if there is no one sellers to it, there is not much of investment of environment to go buy it.
That’s not the case right now, banks are at least in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, the accounting team does a all host of factors that have made them more likely to be source and in fact they have been source, and so we saw this coming a year ago roughly through our servicing business right we’ve run that business fairly dramatically and but I got, this will be perfect REIT asset you could own it free of tax in a passer of vehicle, it generates lot of cash flow on a current basis, if you can own in the right structure this would be a perfect thing to do, that was a the genesis of our conversations with the IRS and the respond to us in the Private Letter Ruling.
The last piece of the puzzle is to make sure though that the partnership, the structure that has put in place between ourselves as an owner of an excess servicing right, and whoever the servicer might be, and we think there is a number of qualified services, but again to be qualified in my view, you have to have three very distinct characteristics. One is, you have to be a great servicer, right, keep the loans current and we’re not. Two is you have to be a great originator, because this reorigination aspect of it is a critical element of defeating the one really material risk of an MSR. And third, this is lots of a tangible issue more, just kind of a red light, green light issue is, the counterparty has to have real capital to put at risk, because alignment of interests on any partnership is central to its ultimate performance.
And so if you line up those three characteristics, there is more than one counterparty, but there is probably not more than 10. So it’s a relatively short list, we’re working on this in a couple of different situations and just trying to be very transparent and tell you what we’re thinking about. And as this thing comes to past and we’ll give you the information. And I think based on what we see in the world, this is one of the single most interesting investment areas in the U.S., certainly on the financial services area. So it’s something we’re really focused on. And that’s why we’re excited about it. So –
Joshua Barber – Stifel Nicolaus
Okay, not to get ahead of things over there. But you made some comments about services being well capitalized. If you are investing in a 50-50 joint venture on those particular IO-strips, would you actually have to be advancing into it on defaulted loans, or that be the full responsibility of the distributors because they retaining the servicing strip?
The percentage that we would invest with a servicing partner, we need to be material enough at that I think that they would care about the return on their capital. So the return of their capital and so if that could be as well as 10% or it’s very large pool might be 50% if it’s small pool or something in the middle. The obligations of the servicers in terms of servicing the loans will stay with servicer. So, with our role in Newcastle as part of this is purely to be a passive owner of the MSRs the excess servicing strip and really the only conditions to that is that we are going to be a participant in the re-origination of those loans which is a net plus. All the rest of servicing obligations would stay with the servicer themselves.
Joshua Barber – Stifel Nicolaus
And you wouldn’t have to put up any additional capital in the event that your servicer would actually be the originator of that loan.
Joshua Barber – Stifel Nicolaus
Okay. Changing tax here a little bit you had mentioned on CDO VIII that reinvestment theory does expiring I believe this month. What sort of asset duration is in that CDO today and what kind of flexibility will you have on that after the reinvestment period?
We haven’t disclosed in the 10-Q and the loans I think on average were about four years. So I think we think it will be out there for about four years and actually it didn’t seem to be bought at so much of our CDO debt to the extent that once the pay down start to come in pretty quickly, it’s going to deleverage pretty fast. I think actually we’ll have enough equity in the deal, probably it hopefully do some type of take out where we can pull out on our money.
Joshua Barber – Stifel Nicolaus
Okay. And last question regarding the future equity raises and like I think it was certainly a little surprising to many of us who have seen that. But obviously you guys have some deals speed up. What’s your outlook going forward given the deal, opportunity and where your shares are trading today, your outlook for future equity raises for the next 12 months? I know that’s sort of a broad question but if you can walk us through your thought process?
Well, my thought process is we have to balance the two objectives of any kind of dilution to shareholders with the potential investment returns from the business. And obviously we’re not happy with where the company decide, right now we think that the financial results are terrific and certainly with the deployment of this capital we expect to show a lot of growth in the earnings and prospectively the dividend and share price of the company will reflect that.
So, then there is no plans at this point to raise any new capital. But as Kenny said, nearly $200 million in capital, cash on hand and the balance sheet, so that’s a serious amount of capital to deploy. I mean there is a lot of opportunities in the world, but it’s a high threshold in our world to push one over the line.
So I can’t give any specific guidance because we don’t really have any specific thoughts about it, but we’ll see. I’m very optimistic about the investment of this capital and what the results would be of the company, and then we’ll be measure any further capital raises after that.
Thank you. We have reached the allotted time for questions. I would like to turn it back over to management for closing remarks.
Thanks again for joining us today. We appreciate your participation and we look forward to speaking with you next quarter.
Thank you. This concludes today’s conference call. You may now disconnect.
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